Much Ado about Pigou

Economists, policy analysts, and politicians often rattle the bones of brilliant economists long passed when making a case for a favorite policy or legislative action. John Maynard Keynes has again become a popular icon for justifying deficit spending in the face of severe recession. There are other days when Joseph Schumpeter’s name and “creative destruction” surface to justify marketplace tough love. We hear references to Frederick von Hayek and his notions about property rights, common law, and spontaneous order when the market process is being defended. And of course, Milton Friedman is brought forth when education andmonetary policy are discussed.

The latest long-dead economist to enthrall bloggers, policy wonks, and entrepreneurial analysts is Arthur Cecil Pigou, whose authority is now being used to justify a blizzard of taxes and other actions proposed to serve the public interest. It is Pigou who suggested that a tax can be placed on activities that generate negative externalities, in order to make beneficiaries of the activity consider its full cost.

In November 2009, John Cassidy had this to say in a Wall Street Journal essay:

"Today Mr. Pigou’s intellectual legacy is being rediscovered, and, unlike those of Messrs. Keynes and Friedman, it enjoys bipartisan appeal. Leading Republican leaning economists such as Greg Mankiw and Gary Becker have joined Democrats such as Paul Krugman and Amartya Sen in recommending a Pigovian approach to policy.Much of President Barack Obama’s agenda — financial regulation, cap and trade, health care reform — is an application of Mr.. Pigou’s principles. Whether the president knows it or not, he is a Pigovian."

Greg Mankiw, who was chairman of the Council of Economic Advisers during the George W. Bush administration, has become so dedicated to the idea of imposing a tax on gasoline for social purposes that he has organized a Pigou Society that scores of economists and others have joined. As Mankiw and others see it, a properly designed gasoline tax can compensate for social costs associated with driving automobiles. Those costs relate to traffic congestion, pollution, climate change, and secure delivery of crude oil and refined product.

When adopted in its ideal form, a Pigouvian tax that brings beneficial adjustments to unaccounted-for harms can also bring a collateral benefit: in a perfect policy world, other burdensome taxes can be reduced. For example, properly calibrated taxes on carbon emissions can become a substitute for taxes on labor that yield a shortfall of gross domestic product.When taken together, the two actions happily make the world a better place — unwanted carbon emissions go down and gdp goes up.

Identifying a true social problemand designing an efficient Pigouvian tax to address it are challenging exercises. But it is even more challenging to get politicians to adopt such a tax and bureaucrats to implement it correctly. That is something Pigou understood, but the people who use his name today may not.

THE BANK TAX Consider President Obama’s newly proposed tax on banks. On January 14, the president announced that a Financial Crisis Responsibility Fee should be imposed on non-deposit liabilities held by U.S. banks with $50 billion ormore in assets. The fee would take effect June 30, 2010, and operate for 12 years, during which time analysts calculate it would generate $117 billion in revenues, equal to the expected shortfall of payments from all TARP recipients.

In announcing the plan, Obama put populist red meat on the table when he said:

"My commitment is to recover every single dime the American people are owed. And my determination to achieve this goal is only heightened when I see reports of massive profits and obscene bonuses at the very firms who owe their continued existence to the American people — who have not been made whole, and who continue to face real hardship in this recession. That’s why I’m proposing a Financial Crisis Responsibility Fee to be imposed on major financial firms until the American people are fully compensated for the extraordinary assistance they provided toWall Street.

In a radio address following his announcement, the president suggested another reason for the fee, a reason that should make modern-day Pigouvians very happy:

"Only the largest financial firms with more than $50 billion in assets will be affected, not community banks. And the bigger the firm — and the more debt it holds — the larger the fee. Because we are not only going to recover our money and help close our deficits; we are going to attack some of the banking practices that led to the crisis."

Taking in all this, the Economist magazine commented: “But politics is not the onlymotive. Hitting the giants addresses a genuine concern about banks whose size poses systemic dangers.” Chiming in and hitting the nail on the head, Seeking Alpha writer KindredWinecoff heard the rattle of Pigou’s bones and said:

"This is essentially a tax on risk, because it targets leverage ratios. In terms of economic theory, or even social justice, this makes some sense. Think of it as a Pigouvian tax: moral hazard exists for firms with an explicit government guarantee, so this tax could help bring private and social costs in line. In other words, it could help banks internalize the social costs of their actions."

In a matter of a few days, the bank fee explanation transformed from a tax for generating revenue, to a tax for reducing sin, to a Pigouvian tax that wouldmake the world better off.

Interestingly enough, the proposed bank tax arrived just a few weeks after shoppers in Washington, DC were hit with a newfive-cent tax on paper and plastic bags provided by grocers and retailers. The bag tax was justified as an environmental tax, one that would reduce the careless use and disposal of bags and provide funding to clean up the Anacostia River. Patrick Gleason of Americans for Tax Reform described the matter thus: “Washingtonians heading out in search of VitaminWater and bacon to cure their New Year’s morning hangovers will be greeted by a new Pigouvian tax at the checkout.” In his extended comments, Gleason suggested that the revenuewould just be used to form another slush fund for political purposes, that it was more about revenue than the environment.

Today, there is much ado about Pigou. To cite a few more instances of this, there are non-returnable bottle taxes to fight litter, snack and soda taxes to fight obesity, carbon and nitrogen oxide taxes in Scandinavia to fight global warming, and petrol taxes across Europe and the United Kingdom. All are justified in part as Pigouvian taxes that happily and harmlessly nudge human behavior in the right direction.

PIGOUVIAN SOLUTION Pigou was a Cambridge University don who had studied under the great economist Alfred Marshall, held the university’s leading economics chair, and strongly supported JohnMaynard Keynes. Pigou was a prodigious writer and contributed to multiple strands of economic thought, but his reputation was earned for proposing the use of taxes to reduce activities that impose externalities — costs not taken into account by those who earn their profits from the costgenerating activities.

Writing in 1920, Pigou offered air pollution as an example of unaccounted- for costs and spoke in terms of divergences between private and social product: “Smoke in large cities imposes a heavy uncharged loss on the community, in injury to buildings, vegetation, expenses for washing clothes and cleaning rooms, expenses for the provision of artificial light, and inmany other ways.” Air pollution was just one example. Pigou saw social cost problems everywhere, or so it seems. There were too many cars forming traffic congestion, excessive alcohol consumption that damaged innocent people, too many vehicles wearing out highways, and too much work done by women in factories, which, in his view, imposed unrecognized costs on their children.

On the other side of the coin, Pigou called for subsidies, or what he called bounties, to expand activities that produced dispersed benefits that did not generatemoney in the till of the producer. These included planting forests that improved the environment, operating lighthouses that guided nonpaying shippers, and providing street lights that reduced crime. Based on strictly theoretical grounds, which is to say without the benefit of field work or data analysis, Pigou found a host of situations where markets simply led to faulty outcomes. He concluded:

"No “invisible hand” can be relied on to produce a good arrangement of the whole froma combination of separate treatments of the parts. It is therefore necessary that an authority of wider reach should intervene to tackle the collective problems of beauty, of air and light, as those other collective problems of gas and water have been tackled."

He then proposed:

"It is, however, possible for the State, if it so chooses, to remove the divergence in any field by “extraordinary encouragements” or “extraordinary restraints” upon investments in that field. The most obvious forms which these encouragements and restraintsmay assume are, of course, those of bounties and taxes."

In short, government taxes and subsidies are a required constraint on markets to bring balance between costs and benefits when there are spillovers not accounted for by private actors. But the taxes have to be carefully calibrated so that the tax paid at the margin is just equal to the cost imposed. A similar calculus is required for subsidies. What is done with any resulting net revenues is another matter.

And there we have the Pigouvian solution. To correct problems of systemic risk generated by large banks, overly nutritious drinks that lead to obesity, too much carbon emissions that may contribute to climate change, or too many grocery bags that ultimately foul the environment, a wise government can design just the right tax or subsidy and gently adjust the economic mechanism so that it runs more perfectly.

This proposal ultimately generated a massive academic debate. Chief among the debaters was Ronald H. Coase, who would later receive a Nobel prize in part for his contribution. Coase pointed out that markets failed to operate effectively only when property rights and rules of liability are not well defined, or when transaction costs restrict exchange.He noted that lighthouse operators long ago solved the problemof collecting fees from ships that benefited from their light. This response exemplified the institutional vacuum in which Pigou had conducted his analysis.Coase’s classic 1960 article “The Problem of Social Cost,” explaining all this, became the most cited academic paper in both lawand economics.However,while Coase easilywon the academic debate, at least as measured by citations, conferences, and books built around his ideas, Pigou seems to have won the policy debate.

PIGOU’S WARNING As strange as it may seem, Pigou did not believe that government could improve human well being by fine-tuning behavior with taxes, subsidies, and regulation. His concern was grounded in what we today call Public Choice. He did not accept the notion that politicians, given constitutional constraints, would be capable of implementing an efficient and effective set of taxes and subsidies. Put simply, he did not believe the politicians could get the calculations right. Instead ofmaking things better, the chances were just as good that things would be made worse. Instead of keeping faith with implementing a welldesigned tax, the politicians’ interest would be deflected to writing loopholes for favored interest groups and finding ways to generate evermore revenue.

In 1932, after describing the theoretically ideal outcome that could be achieved by his much-discussed mechanisms, Pigou confronted the politics of the problem and wrote:

"[W]e cannot expect that any public authority will attain, or will even wholeheartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure and to personal corruption by private interest. A loud-voice part of their constituents, if organized for votes, may easily outweigh the whole."

It would seemthat Pigou was notmuch of a Pigouvian.

Applied today, his warning suggests that instead of offsetting the cost of systemic risk, the purpose of the bank tax likely is to punish high-paid bankers (or at least make the public believe the bankers are being punished), or just simply to raise revenue for a deficit-plagued government.

But what about more traditional forms of Pigouvian taxes, such as those supposedly intended to reduce pollution and improve human well being? Are such taxes truly intended to reduce harms efficiently, or are they about something else, like raising government revenue? In an effort to answer this question for environmental taxes, in 2003 Elizabethtown College professor Cristina Ciocirlan and I analyzed tax revenues generated by all of the green taxes used by oecd countries, presumably to improve environmental quality. These include taxes on electricity and cement production, coal, petroleum, natural gas, waste, and packaging materials.

Ciocirlan’s statistical estimates enabled us to test hypotheses about the underlying purpose of the tax system: was the purpose to protect human health or just to raise government revenue? To this end, we examined a statistically derived green tax revenue function and tested competing hypotheses regarding political behavior. For example, we included variables that adjusted for human health, reasoning that, all else equal, emission tax revenues would be higher where human health is lower. (We found that revenues were lower where human health sufferedmost.)We also examined the role played by green tax exemptions provided to special interest groups. Did revenues go up or down with exemptions? If up, we would infer that the politicians were taking action tomaximize revenues. (It turned out that revenue went up with exemptions.) We then tested the shape of the revenue function, which enabled us to infer if the authorities set taxes to maximize revenue or maximize emission reductions. Our robust findings did not support the classic Pigouvian goal, but rather supported Pigou’s later concern. The end result seemed to be more about generating money for government than about protecting human health.

CONCLUSION Today there is much ado about Arthur Cecil Pigou. Butmuch of it is unjustified, at least in the view expressed by Pigou himself. Clearly, politicians and pundits need intellectual justification for their actions and opinions, but it is inappropriate to hang taxes and regulations that are claimed to make things better around the neck of Pigou. It is not that taxes, regulations, and subsidies are ineffective in changing behavior. Indeed, we all know that incentivesmatter. Nudges work. But the real question is, do those political instrumentsmake things better? That remains an open question.

Bruce Yandle is a consultant, writer and speaker on economics and political economy. He is Mercatus Center Distinguished Adjunct Professor of Economics at George Mason University and participates regulatory in the Center’s Capitol Hill lecture series. Yandle is Dean Emeritus of Clemson University’s College of Business & Behavioral Science and...

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